The Fundamental Difference Between Mainstream and Heterodox Economics

Simon Wren-Lewis discusses the large gap between mainstream and heterodox economics, and asks why the heterodox economists are so willing to throw out almost every aspect of neoclassical theory. Allow me to offer an explanation.

The reason heterodox economists remain dissatisfied with mainstream economics, no matter how many modifications the latter adds to its core framework, is that there is always an implication that, in the absence of various real world ‘frictions’, the economy would function like a smoothly oiled machine. That is: assuming perfect information, mobility, ‘small’ firms, no unions, flexible prices/wages and so forth, the economy would achieve full employment, with near perfect utilisation of resources, and stay there, perhaps buffeted by mild external shocks.

New Keynesians and New Classicals sometimes act like bitter rivals, but mainly they only differ on which ‘frictions’ should be present or not (this is an oversimplification of the disagreement, of course). The original New Classical models started with economies that are always in equilibrium, preferences are constant, and competition is perfect. New Keynesian models add imperfect competition, sticky prices, transaction costs and so forth. The newest papers go further and add heterogeneous agents (which generally means two), changing preferences, and other ‘frictions.’ However, it is assumed that if the economy were rid some specific features/characteristics, it would function similarly to one of the core Walrasian or Arrow-Debreu style formulations.

So is it not true that real world mechanics prevent things from going as smoothly as they might do in absence of those mechanics? Well, partially. But according to heterodox economists, capitalism has inherent tendencies to crisis, unemployment and misallocation anyway.

A key example of where this is evident is finance. Generally the mainstream analyses of why finance is unstable focus on irrationality, imperfect information, externalities and other such modifications. If only everyone had access to information, if transactions were cost less, and if people were rational self maximisers, then finance would be stable.

Minskyites, on the other hand, argue that this isn’t the real problem. Even if the economy starts stable, the resultant strong returns on investments will cause capitalists/investors to take more risk. This process will continue and the economy will endogenously destabilise itself as higher returns are sought and more risk is taken on, until eventually the capacity to make a return on these risks is outrun and we face a collapse. There is no need to invoke a specific ‘friction’ for this process to occur.*

Another prominent example is the labour market. Generally, economists presume that without ‘search costs’, oversized firms/unions and sticky wages, the economy would achieve full employment. But heterodox economists disagree on a number of counts: the Marginal Value Product Theory is faulty, so higher wages will not necessarily cause unemployment to rise; wages are also an essential component of aggregate demand, so reducing them may well be counterproductive. In fact, Keynes argued that sticky wages were far from a barrier to full employment; they actually stabilised aggregate demand. Steve Keen’s model also produces less severe business cycles when sticky wages and prices are added.

So the reason heterodox economists want to throw the proverbial baby out with the bath water (and also redecorate the bathroom and possibly even move house, or something), is that they think the core of mainstream economics has dug itself too deep into a ditch. The inevitable ad hoc modifications of ‘perfect’ models sometimes have so many ‘frictions’ introduced that the supposed ‘deep’ mechanics that underlie them become questionable. But they are still never abandoned. Heterodox economics is not just about adding a few real world mechanics here and there; it’s about throwing out the entire core and starting over.

*It could be said that this might not occur if Knightian uncertainty were not a factor in the real world, but I think calling this a ‘friction’ jumps the gap between friction and fundamental reality.

I think my biggest complaint about orthodox Equilibrium modeling today is the fact that modelers do not recognize the fact that inflation-rates vary across different income groups. The very concept of The Price Level is an absurd oversimplification that hides much important information from the eyes of the macroeconomic analyst.

When you reduce the tax obligations of the wealthy across-the-board, the resulting increase in their disposable incomes fuels a robust round of inflation that all the wealthy collectively experience. It is reflected in the dramatic increase in the prices of luxuries and assets.

If economists had bothered themselves to calculate the inflation rates of different income groups over the past couple of decades, they would have noticed that the upper-class experienced double-digit price inflation at the same time that the lower-classes were experiencing—due to outsourcing, expanded immigration, ‘globalization’—disinflation, or even outright deflation.

Perhaps modelers would have noticed from the correlation of upper-class inflation with the growth of two asset bubbles that the tax cuts had largely provided the ‘fuel’ that (1) fed two disastrous asset bubbles, and (2) inspired bankers to throw a growing surfeit of loanable reserves at ever-riskier borrowers.

Macroeconomic modelers like to think that they are quite clever when they include such dubious variables as ‘expectations’ and ‘permanent income calculations’ in their models (assigning them much more weight than they deserve), but then they simply ignore the huge significance of varying inflation-rates across income groups.

I can’t link you to them because I am not aware of any person/entity calculating them. But I can tell you how to compile them. A spectrum of calculated inflation rates for different income brackets could be produced the same way current “average” inflation rates are created.

Instead of tracking only the changes in prices of a ‘market basket’ of goods/services purchased by ‘average’ citizens (in the U.S., a ‘typical’ urban wage earner’s purchases are tracked), different market baskets reflecting the purchasing habits of individuals who enjoy different levels of income would be tracked.

For the wealthy, this would have to include the changing prices of assets that are typically held as financial investments (properly weighted, of course, reflecting the percentage of the total income spent on each category of purchases). This is important because it is a big part of “the cost of being rich.”

The use of a single “average” inflation rate is usually justified as a necessary simplification of the model, but it is the kind of simplification that excludes really important information.

In the U.S., back in the 1980’s, some (many?) economists were mystified as to why the big increase in the money supply was not being reflected in ‘the inflation rate.’

The answer was because almost all of that increase in the money supply was being enjoyed by the upper-class, who were then benefiting from Reagan’s big tax cuts. The same is true, of course, today.

You see, the wealthy really don’t worry about inflation if it is only they who get to enjoy it. They only worry about increasing inflation rates when they are useful approximations of ‘labor costs.’

Prices in an index are weighted, of course, because failure to do so will generate numbers that tell us little re: changes in the ‘cost-of-living.’

For example, in a given period, if significant price increases only occur for those items in the market basket that cost very little, like thumbtacks and gumballs, then the calculated index number will exaggerate the change in a household’s the cost-of-living.

That is to say, if the prices of thumbtacks and gumballs doubled and and each of those items was included in the market basket and were each given equal ‘weight’ with all the other items in the MB, then a significant increase in ‘measured inflation’ would be the result, but the actual change in the typical household’s cost-of-living would be very tiny.

Compare that scenario to one in which the price of automobiles (included in the index) increased by only one half of one percent at the same time that the prices of all other items in the MB held steady. Then the measured inflation rate would be tiny, but the total increase in the typical household’s cost-of-living would be much greater than in first scenario (assuming an auto was purchased).

That is why purchases are weighted, to better reflect the actual change in a household’s cost-of-living. If big ticket purchases, infrequently made, are given equal weight with gumballs, distorted results are produced. If individual purchases are weighted to reflect the percentage of the household’s total expenditures, a better measurement of a typical household’s cost-of-living from month to month is produced.

Well, apparently the wealthy enjoy it very much, at least when it is only they who are experiencing it. This is a fair conclusion to arrive at, since their political minions (at least here in the U.S.) are still arguing for changes in tax policy that are guaranteed to bring on another round of inflation for the upper-class, and nothing more.

Whenever big tax cuts are given to ALL rich people, none of them is able to use their increased disposable income to gain a a purchasing power advantage over others in those markets that largely serve the rich (luxuries, assets). The prices of the scarcest G’s and S’s will simply increase until all of those extra pounds/dollars are ‘absorbed’ by the marketplace.

The only assumption this assertion depends on is the belief that suppliers will charge as much as their markets will bear, an assumption that almost every free-market economist in the world assumes to be largely true.

If you were to throw all of that money at the lower classes, at least over a period of time you would see some resource allocation, but when you throw it at rich people, there is typically very little that merchants could do with the extra money to increase supply that isn’t already being done.

So they ‘enjoy’ inflation, but do not benefit from it in real terms. Everything they purchase with their tax cut money, they would have been able to get anyway, even if they had never received their tax cuts (only at lower prices).

I’m more inclined to the related idea that additional income to the top doesn’t drive much additional utility because at that point it’s about rank and self-actualisation (like what is the value of what you have created) rather than consumption in the narrow sense.

I wouldn’t doubt that real estate prices in the most desirable locations in the world also capture a lot of the increased income to the wealthy since that is an auction. However it’s not like NYC, SF, and Monaco are the only places elites hang out, and mobility is valued–so I’m saying it’s not that thin of a market (and who says that luxury goods customers are loyal? Unlike groceries they don’t need to keep buying).

When I researched a thesis paper I wrote on this topic back in graduate school, I found theoretical justifications for including changing asset prices in calculated inflation rates, but not any proposals that a spectrum of inflations rates be compiled by government statisticians for use by modelers.

…most macroeconomic models use a single representative agent, or sometimes two. Different income groups or ‘classes’ are generally avoided.

BTW, I think you do a good job here explaining why Heterodox economists feel a sort of revulsion for the neoclassical model, especially…

The inevitable ad hoc modifications of ‘perfect’ models sometimes have so many ‘frictions’ introduced that the supposed ‘deep’ mechanics that underlie them become questionable.SWL wonders why heterodox economists are not content to build upon the age-old NC Equilibrium model because he doesn’t want to believe that the NC model is as discredited as it actually is.

Modeling the economy is a great idea. But why on earth build it upon the notion that the economy would always ‘fix itself’, whenever it experiences a ‘shock’, if only the government would keep itself out of the problem? Why is that considered an inherently superior economic Ideal to pursue?

Why not employ a modeling of the economy that helps to explain to the citizenry what must happen in order for EVERYONE to become richer? Or at least as rich as possible?

IMO, an ideal modeling of the macroeconomy would clearly highlight the fact that wealth optimization is possible when X economic activities are performed at Y levels of optimization. Isn’t that what we are all really interested in?

It makes me wonder if there something [not generally known] about mathematically-inclined economists that makes them naturally reluctant to construct such a model?

True – there’s Econophysics, who well and truly want to throw the baby out with the bathwater. I think they have much to contribute but have some sympathy with this view.

There are post-Keynesians, which are who I generally have in mind when I speak of ‘heterodox’ economists. I consider Sraffians and MMTers closely linked with PKs, though there are differences. There are also institutionalists, who I believe are also linked with PKs but don’t know much about.

I saw a list under the google search of “Post-Autistic Economics” several years ago which seemed very heterogeneous.

Institutionalists — is that like neo-instutiontional economics (I have a oxf p volume in another library where the [icelandic?] authors use simple games to describe the social structure — eg sharecropping)

But I’m not really an expert on the diversity–I just know it is in fact diverse.

That’s a funny comic about the econophysicists. I don’t really have a sympathy for them, b/c I disagree with the aesthetics of their models. Perhaps I am just addicted to the old econ ways, but I think models that start with individual behaviour and response to the conditions they find themselves in make more sense than “Prices do a percolation process because … because we have a model for that!”

Unlearningecon: Since you mention the econophysicists now, does it mean that you finally are taking them seriously? Was the first time you heard of the econophysics project due to my guest posts at Facts and Other Stubborn Things? On another note: not all of them want to overthrow neoclassical economics, I might add, and some of them are friendlier to working with the economics profession.

I read ‘Economyths’ by David Orrell and liked it – I’ve always thought they have an interesting approach and will read morre in the future. However, I find Econophysicists are more likely than others to fall into the traps I spoke about in my recent post ‘How Not to Criticise Economics.’

As for your point on the traps that the econophysicists fall into: not necessarily. H.E. Stanley has worked with economists before, including a rising star named Xavier Gabaix (sp?). And Joseph L. McCauley has a good command of mainstream literature, even though I might not agree with all of his criticisms.

The purported strength of new-classical and new-Keynesian macroeconomics is that they have firm anchorage in preference-based microeconomics, and especially the decisions taken by inter-temporal utility maximizing “forward-loooking” individuals.

To some of us, however, this has come at too high a price. The almost quasi-religious insistence that macroeconomics has to have microfoundations – without ever presenting neither ontological nor epistemological justifications for this claim – has put a blind eye to the weakness of the whole enterprise of trying to depict a complex economy based on an all-embracing representative actor equipped with superhuman knowledge, forecasting abilities and forward-looking rational expectations”